Option Pricing and Replication with Transactions Costs

Transactions costs invalidate the Black-Scholes arbitrage argument for option pricing, since continuous revision implies infinite trading. Discrete revision using Black-Scholes deltas generates errors which are correlated with the market, and do not approach zero with more frequent revision when transactions costs are included. This paper develops a modified option replicating strategy which depends on the size of transactions costs and the frequency of revision. Hedging errors are uncorrelated with the market and approach zero with more frequent revision. The technique permits calculation of the transactions costs of option replication and provides bounds on option prices.     

Optimal Capital Structure,Endogenous Bankruptcy,and the Term Structure of Credit Spreads

This article examines the optimal capital structure of a firm that can choose both the amount and maturity of its debt. Bankruptcy is determined endogenously rather than by the imposition of a positive net worth condition or by a cash flow constraint. The results extend Leland's (1994a) closed-form results to a much richer class of possible debt structures and permit study of the optimal maturity of debt as well as the optimal amount of debt. The model predicts leverage, credit spreads, default rates, and writedowns, which accord quite closely with historical averages. While short term debt does not exploit tax benefits as completely as long term debt, it is more likely to provide incentive compatibility between debt holders and equity holders. Short term debt reduces or eliminates “asset substitution” agency costs. The tax advantage of debt must be balanced against bankruptcy and agency costs in determining the optimal maturity of the capital structure. The model predicts differently shaped term structures of credit spreads for different levels of risk. These term structures are similar to those found empirically by Sarig and Warga (1989). Our results have important implications for bond portfolio management. In general, Macaulay duration dramatically overstates true duration of risky debt, which may be negative for “junk” bonds. Furthermore, the “convexity” of bond prices can become “concavity.”     

Symposium on Public Policy Issues in Finance

The thesis of this symposium, organized by James Bicksler, was that while finance theory will surely inform practitioners, it seems appropriate to pay some attention to the opposite flow: practitioners can inform theory. Contributors include a distinguished group of practitioners with extensive backgrounds in economics, and economists with extensive public policy experience: Martin Feldstein, Robert Glauber, David Mullins, and Steven Wallman. Their topics range from privatizing social security, to managing market crashes, to the regulatory agency cost problem, to regulatory constraints in a technologically advanced world.     

Corporate Debt Value,Bond Covenants,and Optimal Capital Structure

This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.     

Free Cash Flow,Shareholder Value,and the Undistributed Profits Tax of 1936 and 1937

In 1936, the Federal Government unexpectedly imposed a tax on undistributed corporate profits. Despite the direct costs of the tax, its announcement produced a positive revaluation of corporate equity, particularly among lower-payout firms. We interpret this as evidence of a divergence between managerial and shareholder preferences regarding dividend payout policies, consistent with the presence of agency costs. We also find that despite the incentives created by the tax, the actual growth in dividends during 1936 was lower among firms judged more likely to be subject to higher agency costs after controlling for liquidity, debt, and the growth in earnings.     

Union Wage Effects and the Probability of Union Membership*

This paper uses Lee's (1978) model to determine the wage gains associated with trade union membership and the reasons individuals join trade unions in Australia The data are derived from the 1984 Australian National Social Science Survey. A major conclusion is that unions secure a 17.22 per cent wage gain for their members, other things the same. This expected wage premium is shown to have an important positive impact upon the union membership decision. The welfare loss associated with the union wage premium is argued to be relatively minor about one half of one per cent of gross domestic product     

Information Intermediary or De Facto Standard Setter? Field Evidence on the Indirect and Direct Influence of Proxy Advisors

We examine whether proxy advisory firms (PAs) serve primarily an information intermediary role by providing research and voting recommendations to shareholders, or directly influence executive compensation by exerting pressure on firms to adopt preferred pay practices. Through a field study, we find that PAs are perceived as both information intermediaries and agenda setters and that these roles provide leverage to enable PAs to exercise significant influence over executive pay practices. Boards feel, and sometimes yield to, pressure to conform to PA “best” practices despite their own preferred compensation philosophies, even in the absence of overt PA scrutiny or negative shareholder votes. We also find that PAs are susceptible to conflicts of interest and generally use a “one‐size‐fits‐all” approach to voting recommendations. Overall, however, PAs are viewed as improving compensation practices by increasing transparency and accountability and fostering dialogue between firms and their shareholders.     

Why Did NASDAQ Market Makers Stop Avoiding Odd-Eighth Quotes?

On May 26 and 27, 1994 several national newspapers reported the findings of Christie and Schultz (1994) who cannot reject the hypothesis that market makers of active NASDAQ stocks implicitly colluded to maintain spreads of at least $0.25 by avoiding odd-eighth quotes. On May 27, dealers in Amgen, Cisco Systems, and Microsoft sharply increased their use of odd-eighth quotes, and mean inside and effective spreads fell nearly 50 percent. This pattern was repeated for Apple Computer the following trading day. Using individual dealer quotes for Apple and Microsoft, we find that virtually all dealers moved in unison to adopt odd-eighth quotes.     

Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes?

The NASDAQ multiple dealer market is designed to produce narrow bid-ask spreads through the competition for order flow among individual dealers. However, we find that odd-eighth quotes are virtually nonexistent for 70 of 100 actively traded NASDAQ securities, including Apple Computer and Lotus Development. The lack of odd-eighth quotes cannot be explained by the negotiation hypothesis of Harris (1991) , trading activity, or other variables thought to impact spreads. This result implies that the inside spread for a large number of NASDAQ stocks is at least $0.25 and raises the question of whether NASDAQ dealers implicitly collude to maintain wide spreads.